Home > Disaster Risk: Using Capital Markets to Protect Against the Cost of Catastrophes

Disaster Risk: Using Capital Markets to Protect Against the Cost of Catastrophes

Submitted by Michael Bennett On Mon, 08/11/2014

Hurricane Sandy / NOAA

In addition to their often devastating human toll, natural disasters can have an extremely adverse economic impact on countries. Disasters can be particularly calamitous for developing countries because of the low level of insurance penetration in those countries. Only about 1% of natural disaster-related losses between 1980 and 2004 in developing countries were insured, compared to approximately 30% in developed countries. This means the financial burden of natural disasters in developing countries falls primarily on governments, which are often forced to reallocate budget resources to finance disaster response and recovery. At the same time, their revenues are typically falling because of decreased economic activity following a disaster. The result is less money for government priorities like education or health, thereby magnifying the negative developmental impact of a disaster.

To address this problem, the World Bank Treasury has been helping our clients protect their public finances in the event of a natural disaster. The most recent innovation is our new Capital-at-Risk Notes program, which allows our clients to access the capital markets through the World Bank to hedge their natural disaster risk. Under the program, the World Bank issues a bond supported by the strength of our own balance sheet, and hedges it through a swap or similar contract with our client. The program allows us to transfer risks from our clients to the capital markets, where interest in catastrophe bonds is growing.

During the past decade, capital markets instruments, such as catastrophe bonds and swaps, have become an increasingly important part of the global re-insurance market. The catastrophe bond market has attracted large amounts of new capital in recent years as investors look to this market as a potential source of attractive, uncorrelated returns in what otherwise is generally a low yielding/high correlation investment universe. This influx of new capital has pushed down pricing and created a very favorable environment for a bond issuer or sponsor. Capital markets instruments now represent around 15% of the total volume of global catastrophe re-insurance.

Catastrophe bonds allow entities that are exposed to natural disaster risk, such as insurance companies, to transfer a portion of that risk to bond investors. In a typical catastrophe bond structure, the entity exposed to the risk (known as the “sponsor” of the bond) enters into an insurance contract with a special purpose vehicle (SPV) that issues the bonds to investors. The SPV invests the proceeds of the bond issuance in highly rated securities that are held in a collateral trust, and it transfers the return on this collateral, together with the insurance premiums received from the sponsor, to the investors as periodic coupons on the bonds. If a specified natural disaster occurs during the term of the bond, some or all of the assets held as collateral are liquidated and that money is paid to the sponsor as a pay-out under its insurance contract with the SPV. If no specified event occurs, the collateral assets are liquidated on the maturity date of the bonds and the money is paid to the investors. In other words, investors risk losing some or all of their principal if a natural disaster occurs, and in exchange receive a coupon that reflects the insurance premium for such risk.

Catastrophe bonds have grown at a rapid pace since their introduction in the 1990s. In just the first half of 2014, $5.7 billion of catastrophe bonds were issued, compared to about $2 billion issued for all of 2005.

Despite the rapid growth of the market, the risks covered by catastrophe bonds remain highly concentrated in a small number of perils — hurricanes in the southeastern United States, earthquakes in California, windstorms in Europe and earthquakes in Japan. Catastrophe bond investors are eager to invest in other types of risks to diversify their portfolios – in fact, the demand for catastrophe bonds that reference diversifying risks is so strong that these bonds generally price at a significantly lower level than bonds with an equivalent level of risk that reference the main perils in the market.

However, while the high demand for diversifying risks creates an incentive for developing country governments to obtain natural disaster insurance protection through the catastrophe bond market, there remain significant barriers to entry into this market for governments, including: (1) a lack of familiarity among many government officials with re-insurance in general and the catastrophe bond market in particular; (2) limited or non-existent modeling of the natural disaster risk exposure of many countries; (3) potential political risks of purchasing insurance protection when the pay-out is uncertain; and (4) discomfort of many government officials with the complex legal documentation and relatively high transaction costs required for these kinds of transactions.
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Helping clients overcome these kinds of barriers is one of the objectives of our work in this area. Our first foray into the catastrophe bond sector was in 2009 when we created the MultiCat program. This program, for which the World Bank Treasury acts as arranger, allows our clients to sponsor catastrophe bonds using a common documentation platform that makes issuance more efficient, in terms of both time and cost, than doing a stand-alone transaction. The Government of Mexico has used the MultiCat program to sponsor catastrophe bonds covering both earthquake and hurricane risk in 2009 and then again 2012[3] to efficiently transfer a pool of disaster risk to the capital markets.

The most recent Capital-at-Risk Notes program streamlines the process further by eliminating the need for an SPV or a collateral arrangement. Instead, the World Bank issues the bond supported by the strength of its own balance sheet and enters into a swap with our client allowing us to transfer risks from our clients to the capital markets in an extremely efficient way with minimal transaction costs.

Catastrophe bonds are one tool that developing country governments can use to protect their public finances against the impact of natural disasters. Developing country governments can benefit from the surge in demand for catastrophe bonds, particularly since they are bringing to the market attractive diversifying risks. The World Bank Treasury is working with our clients to facilitate this process and make the catastrophe bond market an efficient source of risk transfer for developing countries.
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For more information contact Michael Bennett[4].